Why stopping the next financial crash is an impossible dream

The boom and bust cycle is here to stay

Stock exchange
(Image credit: (Bettmann/CORBIS))

Robert Shiller, who shared 2013’s Nobel Prize for Economics, is worried about the financial system, and wants to see measures taken to prevent future crashes:

Just as most people are more interested in stories about fires than they are in the chemistry of fire retardants, they are more interested in stories about financial crashes than they are in the measures needed to prevent them. That is not a recipe for a happy ending. [Project Syndicate]

But are financial crashes really preventable? I don’t think so. The world is just too unpredictable.

First off, changes to the price of assets are very hard to foresee — their value is not just based on what people think they are worth today, but what people believe other people will think they are worth in the future. It's as messy as it sounds.

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Second, there are all kinds of uncontrollable and unpredictable events — like wars, terrorism, droughts, hurricanes, pandemics, technological and scientific discoveries — that can completely change investors' perceptions and precipitate a financial crash or a financial boom. Preventing every financial crash or burst asset bubble would mean preventing all of these kinds of shocks.

Beyond that, investors don’t all interpret events in the same way. If inflation rises, many investors today would interpret that as an exciting sign that the economy is recovering. Other investors might interpret it as a dangerous sign that central banks’ unconventional monetary policies are starting to harm the economy.

But, surely, some crashes are preventable? After all, lots of economists and financial pundits — including Robert Shiller — successfully predicted the housing bubble last decade. If Congress and the Federal Reserve had been listening to Shiller and others who warned of a housing bubble, could they have prevented the financial crisis by deflating the housing bubble?

Well, there is no certain way to determine whether prices are really in a bubble or not until the bubble bursts. Sometimes a price rise — like the rising value of land in cities like New York, Chicago or London, or shares in Apple, Microsoft and Google — will hold for a very long time. Sometimes a price rise — like dutch tulip bulbs, shares in Enron, or Beanie Babies — will collapse quickly and disastrously. And many of the pundits who correctly identified the housing bubble whiffed the aftermath. Pundits like Peter Schiff and Marc Faber got the call right on the housing bubble, but have since warned about bubbles in the stock market, in treasury bonds, and in the dollar itself. Identifying bubbles is hard, if not impossible to do consistently.

And on a practical note, who in the government would be in charge of making the call?

Should it be the Fed? The last time the Federal Reserve tried to tighten to deflate a perceived bubble, it actually sparked a financial crash. This was in 1929, the year of the great Wall Street Crash that led to the Great Depression.

What about Congress? Given how it's acted in the past, I am dubious that it would make the difficult decisions necessary to prevent a crash, even if it could. While many blame Congress for inflating the housing bubble last decade, the laws that Congress made that led to the risky government-backed subprime lending didn’t emerge from nowhere. They were in response to massive lobbying by the financial industry, which was looking for easy profit, and constituents who wanted help to become homeowners. If politicians don’t make the laws people want, they get voted out. So it’s hard to expect lawmakers to not make laws that are widely demanded by lots of different groups of people just because of the future possibility of an economic bubble and financial crash.

But these examples are pretty moot: Even if the Fed had acted correctly in the lead up to 2008 or if Congress had not backed subprime lending, there's no guarantee there wouldn’t have been a similar bubble and a financial crash. Why?

As the mid-20th century economist Hyman Minsky put it, stability is destabilizing. The American economy experienced a period of relative stability from the end of stagflation in the early 1980s until the 2008 financial crash. Ben Bernanke called this period The Great Moderation. But how do people react to a stable world? Very often, they become more tolerant of risky behavior.

During the Great Moderation, the financial industry began to make riskier loans at higher leverage ratios, with lower deposits, and even to individuals with no income and no job or assets (NINJAs). And risk-takers began hiding the risks by selling the future income from these risky loans on as asset-backed securities. Financial regulations like Glass-Steagall that separated publicly-guaranteed depository banks from investment banks — and which may have been partially responsible for the relative financial stability between the Great Depression and the 2008 recession — were repealed. Politicians were convinced by the financial industry, and by the long period of relative stability that such curbs on risk-taking were no longer necessary. The long period of stability destabilized the system by making politicians and the financial world more risk-tolerant. Successful regulations became victims of their own success. Stability is destabilizing.

Ultimately, I think we need to move beyond the impossible dream of preventing financial crises before they occur. Laws to prevent theft, fraud, intentionally misleading investors, and gambling with other people’s money or with an implicit guarantee (like Glass-Steagall) are prudent regulations. But they do not eliminate booms and busts. Booms and busts are normal behavior in markets, because the future is so hard to predict and people are so unpredictable.

In the long run, I think policy must focus on being more responsive to the booms and busts of the market by minimizing real world damage as problems occur. This means more firefighting — to prevent damagingly excessive unemployment or a deflationary spiral following a financial crisis. That may not be as clean and satisfying as making the problem go away altogether. But if the problem of financial crashes is inherent to financial markets — which it certainly appears to be — making it go away altogether is not an option.

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John Aziz is the economics and business correspondent at TheWeek.com. He is also an associate editor at Pieria.co.uk. Previously his work has appeared on Business Insider, Zero Hedge, and Noahpinion.